Archive for the ‘IPOs’ Category

Whatever its perceived benefits, HFT is changing the way the stock market operates.

It used to be that companies went public to raise capital; investors took risks by buying company stock, and the company and investors were rewarded when the company used its capital wisely. The principles of supply and demand dictated stock prices, creating an efficient market in which prices adjusted based on market demand.

But HFT is affecting market fundamentals.

The majority of trades taking place today are driven not by company performance, but by tiny inefficiencies that only computers can detect. While investors are advised to “buy and hold” their investments for years, computers are trading in nanoseconds. High-frequency traders also buy and sell options, futures, exchange-traded funds (ETFs), currencies and all other financial instruments that are traded electronically, so its impact goes beyond the stock market.

Individual investors used to be the heart and soul of the stock market. Today, big hedge funds and big banks are making billions of dollars off of HFT based on information that is unavailable to the average investor. Just as small investors were hurt by the 1987 crash, while program trading gave big traders an advantage, technology again is creating an unfair advantage for big investors.

Since its introduction in 1999, electronic trading has transformed the way stock markets operate. Other electronic trading strategies are also having an impact on the market, although not to the degree that HFT is.

We need to keep in mind, though, that computers are only as good as the information that goes into them. Comparisons can be made to the mortgage industry. While there were many other issues involved, the recent financial crisis began after computers took over the processing of mortgages and many unqualified people became homeowners.

Likewise, when computers do the trading on the stock market, removing the human element, mistakes are likely to happen. The more dominant HFT becomes, the bigger the next accident is likely to be.

According to The Wall Street Journal, “A combination of mergers, fewer U.S. IPOs, lower listing costs abroad and a shift in how investors and stockbrokers do their jobs has driven down the number of U.S. stock listings by 43% since the peak in 1997—all during a period when the number of listings outside the U.S. has more than doubled.”

Investors lucky enough to own LinkedIn shares (i.e., employees and a small number of wealthy, well-connected investors) saw their shares more than double in price in a single day, jumping from the initial offering price of $45 to $94.25 by the end of the day. Investors who owned private shares, which were being traded on secondary markets, enjoyed even larger gains.

Prices dropped the next day, as some investors cashed in on their profits, but few who own shares are complaining, given that LinkedIn’s debut was the biggest since 2006.

Unfortunately, though, most companies are not LinkedIn. Companies like LinkedIn, Groupon and Facebook are atypical.

The purpose of an IPO is supposed to be to provide the capital needed for relatively small companies to grow, and the number of small, innovative companies registering for IPOs is still down significantly from past years.

To date, 61 companies have completed IPOs this year, up from 51 at this time last year and only seven in 2009. In contrast, 83 IPOs took place in the first five months of 2007, which is still far short of the 185 deals that took place through May in 2000.

The number of IPOs has fallen for many reasons, including the cost of compliance with the Sarbanes-Oxley Act; Eliot Spitzer’s global research settlement, which resulted in a lack of research for small company stocks; the dot-com bubble, and the financial crisis.

While the average investor has little chance of obtaining stock in a hot IPO, a resurgence of IPOs would be good news, as it would fuel the growth of the next generation of companies that will create jobs, spur economic growth and give the stock market a much-needed boost.